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| Akash Prakash: The dollar carry trade? |
| Akash Prakash / New Delhi Sep 25, 2009, 00:47 IST |
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Investors should be careful in assuming that dollar weakness is a given; this could easily reverse.
Recently we have seen a very strong negative correlation develop between the dollar and an assortment of risk assets. It almost seems that the only thing one has to track every morning is the strength or weakness of the greenback. If the dollar is weak, gold, oil, commodities and equities all will be up, and if the dollar is strengthening, then we have the exact opposite behaviour in these asset classes.
The dollar, it seems, is moving from being the de facto reserve currency of the world towards an additional role as a funding currency for risk-based trades. The dollar is effectively now competing with or even replacing the yen as the favoured funding currency for carry trades. The three-month interest rate differential between the US and a weighted average of its major trading partners has moved from plus 2 per cent a few years back to negative today, highlighting the interest rate advantages of borrowing in the dollar.
The classic yen carry trade involved investors borrowing yen at near-zero interest rates, selling the yen for dollars, and then buying government bonds yielding 4-5 per cent with these dollars. As long as exchange rates did not move against you, the investor could make a clean spread of 5 per cent. The trade would be leveraged at least 10 times to give a potential return of nearly 50 per cent, and on huge size.
The big risk in the above structure is the exchange rate: if the dollar weakened against the yen, then the investor could be sitting on a large loss. Given the highly leveraged nature of the transaction even a small variation in exchange rates could cause serious losses, unless the position is hedged in an appropriate manner. Any hedging of the currency risk will obviously cost money and reduce potential returns.
Given the current very easy liquidity conditions in the US and the desire of the Fed to keep interest rates very low for an extended period of time, one can see the parallels with Japan. There is also a strongly held view that this administration is willing to live with a weak dollar to boost the US domestic economy. You can see the obvious attraction to an investor, a chance to fund risk asset purchases via borrowing at very low rates in a currency which seems to be weak on a multi- year secular basis.
To the extent that this dollar carry trade is now replacing the former yen carry trade, one is seeing purchase of yen to repay the original funding source, and selling of dollars to set up the new dollar carry. In effect investors are moving the funding source from yen to dollars, causing steady upwards pressure on the yen vis-a vis the dollar.
The obvious carry trade today is to fund in dollars, and buy assets in the emerging markets (EM), given the higher growth in these economies, higher returns available and the strengthening bias of their currencies. The prospects of a prolonged period of disappointing returns in the developed markets also suggest that risk capital should continue to flow out of the OECD economies. The dynamic of strong capital flows into the EM world is thus quite clear. EM equities should continue to benefit from these strong capital inflows.
Many dollar bears are pointing to the use of the dollar as a funding source in carry trades to highlight the further downside potential in the currency. They also point to the legacy of unprecedented fiscal and monetary policy action in the US. The US has seemingly led the world in adopting these high-risk policies. Market participants are naturally worried that the move towards quantitative easing (QE) and huge fiscal challenges will debase the dollar. The bears also point to the need for dollar weakness to rebalance the global economy. A third point of view is the likelihood of the dollar weakening as the safe haven trade reverses and investors stop worrying about a great depression.
Given the recent weakness in the greenback it is all too easy to become too bearish. It has become too much of a consensus and very crowded trade. Everyone seems to be convinced that the dollar will continue to weaken.
Funding issues aside, there are many reasons why the current bearishness on the dollar may be misplaced.
First of all, the risk of the dollar being debased by the extraordinary policy response in the US is not reflected in government bond markets, where yields and break-even inflation rates remain low. Much still depends on the exit strategy from QE, but given the extent of the output gap in the US, it seems premature to worry about runaway inflation debasing the dollar.
It also seems likely that if/when the global recovery starts fading and fears of a potential double dip resurface, the safe haven demand for dollars is likely to re-emerge. As risk appetite abates, the dollar will strengthen.
Fears of the dollar being supplanted as the global reserve currency also seem premature, as no real credible alternative exists as of today. It also seems unlikely that the US authorities will actively seek a weaker dollar beyond a point, despite the economic benefits, due to the risks a loss of confidence in the currency will pose to global financial stability. The last thing the world economy needs today is a disorderly sell-off in the dollar.
The reliance of the US on foreign capital is also reducing as households delever, savings rise and the current account deficit shrinks.
The US should also grow much faster next year compared to the eurozone or Japan. Every day brings new confirmation of the strength of the US recovery (yesterday’s jump in the Leading Economic Indicators index being the latest example). In the recent past investors have got used to linking strong economic growth with a weak dollar, but this has not always been the case; the pendulum could easily swing back to the markets linking strong growth with a strong dollar. The amazing resilience and adaptability of the US economy should be in display by next year, as it easily outgrows a stagnant eurozone.
It is difficult to quantify the extent to which the carry trade has caused dollar weakness. International banking statistics provided by the BIS would be a useful source of information, but the data is not timely enough to cover the recent period of dollar depreciation. While the dollar bears are convinced that the currency is a one-way trade, with its new-found role in the carry trade being the latest nail in its coffin, market participants should be cautious. Interest rates are very low across the OECD economies, and given the differing long-term growth outlooks for the US vis-a-vis Europe and Japan, it is not obvious why the dollar should be a more attractive funding currency than euro, sterling or the yen.
Investors should be careful in assuming that dollar weakness is a given; this could easily reverse. Given all the issues corporates in India have had in the recent past with exchange rate derivatives, they would be well advised to think about any long-term leveraged exposure they have which builds in continuous dollar weakness.
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